Over at the Union Square Ventures blog, Fred Wilson discusses the failure rates expected in venture capital. He suggests a third of all deals are hit out of the park, a third are mediocre, and the last third fail (although his own firm’s empirical data suggests more of a 40/40/20 split). He also suggests that the overall cash return on such a portfolio may be 3-4x, which is pretty good if you can get it.

Private equity is quite different; we expect all deals to do well. Not out-of-the-park, but well enough to hit target returns (at least 20% IRR or 2x cash). Private equiteers generally believe this low-risk moderate-return approach is more successful than the high-risk high-return approach favoured by venture capitalists.

Image: Private equity, just sit back and relax [source: Shutterstock]

Now, although this difference in investment strategy may seem subtle, it actually means private equity and venture capital are miles apart in execution. Without decent growth, venture capital is toast. However, even with very low-growth, private equity can still bear fruit. How? Leverage, deal structure and multiple arbitrage.

This isn’t to suggest PE and VC are in any way substitutable. But, like all investments, we can analyse and consider the implications of each strategy.

One of the major implications, especially in mid-market private equity, is that we don’t mind skipping over high-growth businesses. We know there’s less competition for lower-growth businesses and that less competition means lower purchase multiples.  And, with an eye firmly on moderate target returns with very low-risk, we know paying a lower multiple is a great risk mitigator.

We also know that stable revenues are more conducive to leverage, and leverage amplifies our returns. While leverage also amplifies our risk, we know particular deal structures can transfer some of that risk to other investors in exchange for a taper on our returns above a specified target. This is okay for us, because remember, we are more concerned about mitigating risks than overshooting our target by orders of magnitude.

So, as you can see, lower-growth (aka boring) businesses can actually serve our cause more effectively. You may see larger private equity funds going crazy with mid-20s purchase multiples in public markets, but down here at the mid-market level, we have choice. We can invest in the most boring businesses you’ve ever seen, conservatively apply debt, structure the deal well, simplify and organise management, exit when the time is right at a higher multiple, and achieve our objectives, even without significant increases in revenue. In private equity, we love boring.

We come into this world as children, bestowed with raw innocence and besotted with toys, confectionery and attention. But, before we grow into adults and face life’s major decisions, we develop an odd yearning to matter and to be noticed. And, as we slowly lose that raw innocence and develop this yearning, we develop our cunning and calculation (which we invariably use to satiate our yearning to matter).

Now, this concept of being noticed isn’t always an overtly moral concept; people engross themselves in rather obscure pursuits such as dancing, accounting, palm reading, etc. However, even with so many channels to become noticed, the reality is that many of us will never really matter outside of our circle of family and friends. We’ll never make a dent in global poverty and we’ll probably just add to the raft of existing global challenges and conundrums.

But, there’s another way. Why waste our efforts on making a difference (especially one that will help others), when we can just create the appearance that we matter? Why bother with impoverished people when we can spend hours a day at the gym to look like we mean business? Or why bother with environmental conservation when we can get a boob job to become more desirable? Or why even build robust businesses that create jobs and support innovation when we can simply spend thousands of dollars on our attire to create the allusion that we’ve made a difference?

Wow, this post sounds really righteous and holier than thou, but that’s not my intention. If anything, I’m just asking… am I trying to make a difference or trying to appear like I’m making a difference. Is making a difference even that noble? Who knows… but what I do know is that in private equity, investment horizons are long enough to separate those that actually matter and those that just appear to matter. (And in life, well, I guess that’s up to you.)

They say the best salespeople can sell just about anything to anyone: ice to the Eskimos, sun to the Saudis and fire to the Devil. They do this by understanding behaviour, analysing motives and focusing on what matters at the time (which may not be what matters in the long term).

In private equity, we make investments in businesses worth many millions of dollars. The need for negotiation is therefore implicit. But, we don’t just negotiate price, we negotiate terms, contracts, and many other things, which in aggregate, constitute the deal.

I suspect a salesman who can sell ice to Eskimo can also sell a 3x multiple and aggressive anti-compete terms to a founder. But unlike the Eskimo, whom you’ll likely never see again, you may have to work with the founder for many years to come.

If you create resentment now, your great multiple of 3x EBITDA may look like 9x EBITDA in six months when earnings tank due to managerial revolt. You may get comfort from the fact the founder is still invested and wouldn’t want to sacrifice his/her own wealth, but then you’d be ignoring human irrationality and the utopic feeling that comes from revenge.

So what’s my point? I think it’s important to play it fair with founders and managers for the sake of the future. While significant value can be created by a great entry price, significant value can be lost thereafter. I’m not suggesting that you capitulate to founders’ demands, but I suggest we all practice a little foresight. Nothing can beat the power of a fully-aligned, determined and resourceful team (of investors and investees), even a low entry price.

Hiring new staff has always puzzled me. You spend an hour, maybe two, maybe even three to get to know each other. Then you say “I do”, lift the veil, consummate the relationship with a handshake and that’s that. Signed, sealed and delivered.

But, imagine… just imagine you told your mother (or your best friend) that you were about to marry someone after knowing them for only a couple of hours. And, imagine telling them that you didn’t just meet this person randomly. You prepped them on exactly what you were looking for and were truly surprised when they said things that made you happy.

I hear you. Yes, there’s a big difference between employment and marriage. Sure, you see your husband/wife at least three hours a day, while you see your employees only between 10 and 12 hours a day. Agreed; big difference.

So, I’m thinking, all of the wisdom you hear about getting to know someone before marriage should also apply to employment. Moving in with them, enduring their habits, arguing with them, making up with them (hey, hey)… all of the stuff that is prattled on about by older learned folk. Of course by this I mean you should trial them.

Now, I don’t mean put them on probation, so if they kill someone or defraud you for a billion franc you’ll fire them. I mean put them on a fixed contract for a month with the intent that they’ll only be hired temporarily. Naturally, you’ll mention the potential to land a full-time gig, but you’ll also explain the uncertainty. Don’t even give them a title; call them a consultant or executive or something equally vague.

During this period, you can work them into the ground, enjoy a warm ale with them, put them in front of intimidating clients, have at least one heated argument with them and if you’re lucky, you’ll be able to tell if they really have what it takes to work in your esteemed organisation. Sure they can put on an act for a month, but that’s much harder than for just 60 minutes.

The mantra of the private equiteer is maximum return for minimum risk. However, I can’t stress enough that the empahsis is on minimum risk. You see, the magnitude of badness associated with a poor performing fund significantly exceeds the magnitude of greatness associated with an exceptional fund. Maybe not so in venture capital, but definitely so in private equity.

If I achieve a 10x return on my fund, LPs, other PEs and most others will say “they were lucky”. If I achieve a 0.5x return for the fund, everyone will say “they suck”. Both terms are pejorative (hey, life’s unfair), but in one scenario you get to boast 10x returns and in the other you don’t get to boast at all.

So, back to the title of this post, equity returns for debt risk. Private equiteers essentially want all of the upside in a deal and none of the downside.

In public markets, you can achieve this by buying put options against a portfolio or through investing in call options. But we all know there’s a cost, and even with that cost, you rarely mitigate risk 100%.

To achieve the same in private equity, we invest via preferred stock, demand preferred coupons, have veto rights over many business decisions, take a board majority, have the right to fire  senior executives, demand that managers invest, sometimes even demand redeemable preferred stock, etc. We are simply hedging our bets. But, like option strategies in public markets, the hedge isn’t perfect.

Where this idea of equity returns for debt risk really matters, is within a portfolio of assets. Public equity fund managers invest in equity returns for equity risk and that equity risk means that some investments succeed and some fail (and then transaction costs ensure most fund managers achieve sub-market returns).

In a private equity portfolio, our quasi-debt investments don’t incur as much loss from poor performing investments, so portfolio returns can conceivably be above public equity portfolio returns without investee performance being above average. Of course, this doesn’t hold when private equiteers overgear their investments, but think about this one without above-average debt. Especially in current markets, I see private equity characterised more by strict legal terms than mountains of debt. We have made two investments this year that are completely debt-free.

This is just another aberrant thought (following my response to The Economist article) on how private equity can beat public markets.

We’ve all heard the aphorism, a private equity investment is like a marriage. And, it’s even more true once you realise the dependence that private equiteers and managers have on one another. The success of an investment firmly rests on the shoulders of senior management (they operate the business after all), while senior managers are often at the mercy of the various legal controls that private equiteers have over the business (they provided much of the capital).

It is with this thought that I’m relating John Gottman’s marital communication research to private equity. It may sound like an opportunistic and somewhat tenuous connection, but I’ve come to realise how heavily private equity success depends on human factors. What’s more, people are irrational; poor relations could see parties working against each other even if it means working against themselves. And in private equity, the last scenario we want is managers working against the interests of the business.

Gottman has suggested four communication styles that predict the destruction of a relationship (he refers to them as the Four Horsemen of Marital Apocalypse).

1. Defensiveness – the destruction starts with defensiveness; it shows a loss of respect for your wisdom. Symptoms may include investee managers disregarding your advice, arguing excessively, changing opinions to counter yours, or simply using excuses to answer general enquiries. A heart-to-heart, face-to-face, honest and open discussion is all that may be needed to steer the relationship back on course.
2. Criticism - this is about making nonconstructive critical remarks about others. In private equity, this starts with managers attacking the credibility, integrity, usefulness, etc. of their private equity investors. See this as a positive, because it means you’ve caught issues early enough to resolve them. Don’t become too defensive; see it as a sign that you’re not managing your relationships properly. The key is to be open and friendly and show some humility.
3. Contempt - this is more a visceral feeling of distaste or disdain. And unfortunately, it’s difficult to turn back from a truly contemptuous relationship. Once the sight of you makes your manager’s skin crawl, it’s usually too late. Signs of contempt include lack of contact, cold communications and a general feeling that the manager wants nothing to do with you. It is resolvable, but it involves taking large risks and breaking through the cold amour of the contemptuous manager.
4. Stonewalling – according to Gottman, stonewalling is the most dangerous stage of all. It reflects complete apathy, detachment and separation. It’s the point where the manager has already made plans to remove themselves from the situation (even if years away) and now feels an odd contentment that better times are on the horizon. Private equiteers can mistakenly view stonewalling as resolved contempt because the manager seems happier, but this is rarely the case. A potential resolution (from the perspective of the firm) is to bring another partner into the investee and cut all ties. Hopefully, the slate will be wiped clean and the new partner will create a fresh new relationship.

The purpose of talking about these factors is to keep them in mind when making critical decisions that affect investees. Remember there’s much more to success than numbers and contracts; the introduction of a small fee has the potential to change the dynamic of your investee relationship forever and ultimately lead to investment failure. Identifying the four horsemen and having the humility to admit fault is critical to avoiding irreversible damage between your firm and investees.

We people are complex and it’s worth keeping aware of human factors to ensure investment success.

Some of you may not know this (it should be taught in elementary school): the rotation and orbit of planet Earth is powered by the continuous pronouncement (by private equiteers) that private equity only invests in the best management teams. That means, if private equiteers stop drilling this droll into unsuspecting civilians, the world will likely cease to exist. So, in the interests of self-preservation, let’s all keep this little secret to ourselves:

Private equiteers (especially in the mid-market) look for opportunities with a high chance of closure, try to secure great terms on those opportunities and hope they get great managers they can work with. If the mangers don’t work out (too rebellious or clueless), they transition new managers into the investee business. As with any employment process, the best applicant, which agrees to the proposed terms, is hired.

Would a private equiteer prefer to hire the best manager in the industry? Absolutely. Do private equiteers only do deals in which they believe they have the absolute best manager in the industry? Ha!

As I’ve mentioned before, private equiteers don’t enjoy the same luxuries as venture capitalists; we can’t be so selective because we’re dealing with very successful businesses/people whom have myriad options. We do deals that we can do; we don’t go chasing managers hoping to get lucky. Similarly, we don’t limit our options to a single company in any industry (the one with the best manager, whomever that may be); we keep our options open.

So, why do private equiteers insist on spreading this best management team voodoo? Well, it sounds great and is difficult to measure, ergo, who’s to say you’re not investing in the best management team? Also, they have to say that because they don’t have the time, capacity or (often) capability to run these businesses themselves. And, it’s scary to think of a highly geared business with mediocre managers and a trigger-happy PE investor.

What’s more, it doesn’t sound as holistic to sell your firm on its ability to invest on a low multiple, gear a business to the nines, and then sell it at a much higher multiple. The idea of long-term value creation, great managers, entrepreneurial flair and of course total humility is much more… post-financial-crisis-friendly. But, with all of that hate projected on deal-focused private equity firms, I must say there are truly great managers out there with real business experience and the nous/drive/passion to make a long-lasting difference. It’s just a wheat/chaff sorting exercise for LPs.

Let me pose a question: when you invest in a business, as an external investor, how much business risk should you take on in comparison to the founders? Should you take on less risk, since you know less about the business? Should you take on more risk, since the founders have put in more work that you to date (and likely more work in the future)? Or should you take on equal risk as equal partners?

The caveat is that it depends on the price paid. I may pay more to take on less risk, or vice versa. But, for simplicity, let’s assume I pay a fair market rate for a business. So, at this perfect market rate (whatever that means), what risk should I be exposed to in comparison to the founders? And why?

Here are my thoughts on each scenario:

1. The private equiteer takes on more risk than the founders – I don’t agree with this because all the hard work that the founders have contributed is paid for as a multiple of the earnings they’ve created. If they’ve put in 10 years of effort and have $0 EBIT, I feel bad for the founders, but private equiteers can’t be expected to pay for hard work without receiving maintainable earnings. Similarly, the founders’ future work is paid by a salary and the upside of their retained equity.
2. The private equiteer takes on less risk than the founders – I don’t agree with this because the private equiteer has ample opportunity to conduct thorough due diligence (and they sell themselves on this due diligence, so it’s hardly fair that they use it as a basis to take less risk). When you buy something, you have the chance to examine it first, but then it’s caveat emptor – buyer beware. If the economy turns, a new competitor takes market share or technology changes, that’s your problem. You were looking for equity returns and you’ve taken equity risk, so you should be ready for the consequences. With that said, I agree there are exceptions in the cases of fraud, impropriety and lack of care (e.g. investors should be shielded from losses due to founders acting against the interests of the business and new investors).
3. The private equiteer takes on equal risk to the founders – In principle, and in some magical and mythical wonderland, I believe investors and founders should share the same risks. Again, the caveat being that a fair market price is paid and there is no price adjustment for taking more/less risk. This is a marriage, you each have different skills, but the mutual plan (at least for an active investor) is to work towards creating barrels full of value.

I’ll leave that thought for now in hope something more profound comes from it soon. My initial thinking is that most private equity deals do not divide risk proportionally between founders and the fund. Maybe this is positive in a greater good sense, or maybe it’s negative; either way, I sometimes wonder about the triteness of private equiteers claiming aligned interests with founders.

The worst principal-agent scenario is one where the agent (management team) has no equity interest in the investee. The second worst principal-agent scenario is one where management have an equity interest in the investee, but haven’t had to part with any cash for that interest (e.g. stock option plans). The only principal-agent scenario that a private equiteer should ever entertain is one in which the management team invests cold hard cash into the business for an equity share.

Now, you may say the founders have invested enough cash and effort over the years to excuse them. And, you may find that the founders even want to withdraw cash from the business in concert with your investment. But, if the founders are at that stage (i.e. taking money out and winding down), you need another champion to work alongside the founders. That is, a champion willing to invest cash with enthusiasm and with the energy to facilitate exponential growth.

The fact is, private equiteers have their interests spread across a portfolio of investees. So, they really do need someone working within the business on a full-time basis whom feels the same urgency. Stock options without an initial investment are better than no equity interest, but the human psyche is skewed toward a potential loss rather than a potential gain (see this post for more information). That means, a loss of $1m of equity value affects most people much more than the expiry of options with a potential value of $1m. So, get as many people writing checks as possible and you’ll be able to sleep just that little bit easier.

At the smaller end of town (say under $200m of capital), there are a plethora of private equity firms that are individually owned.  Often these owners come from larger firms where they didn’t get along with others or preferred the idea of running their own show (for a larger portion of carry). This isn’t such an unconscionable act in isolation, it’s actually quite industrious, but there are fundamental flaws to single-owner private equity firms.

Private equity firms must have a deep and thorough understanding of deal-making, financial instruments, legal structure, business strategy, and of course, debt management. It’s hard for a single private equiteer to have a deep understanding in all of these areas, which is why it pays to have a range of senior parnters/owners whom do in aggregate. Conversely, most single-owner firms are bottom-heavy and don’t have this diversity and therefore contain much more risk for every stakeholder in the firm.

In addition, here are a number of other important considerations regarding single-owner firms:

1. They’re a textbook example of a dictatorship – one person, with all of their emotions, persuasions and biases has carte blanche over every major decision; decisions such as selecting investees, hiring new staff and leading due diligence. In private equity, two, three and four heads are definitely better than one.
2. Key-man risk is a repellent - investors (limited partners), investees, staff, media, bankers and advisers tend to steer clear of single-owner firms for various reasons. LPs will give a wide berth because there’s increased risk borne by having only one decision maker. Investees will do the same because there is often less value-add from a less experienced team. And staff, if they know better, will steer clear because a dictatorship is not the best place to learn.
3. There is fundamental risk to the fund – as previously noted, most of these single-owner firms are bottom-heavy. If something unpleasant affects the owner, the fund is left with a phalanx of fledglings whom may be versed in the daily ruminations of the firm, but lack the critical relationships to run the fund.
4. They circumvent necessary checks and balances - even otherworldly businesspeople need checks and balances in cases where they aren’t thinking straight, aren’t completely objective, aren’t available or are simply too stubborn or clueless. Companies have boards of directors, Presidents have senior advisers, but single-owner private equity firms only have LPs, whom most of the time are oblivious to what’s really going on (sorry LPs, but it’s true at mid-market level due to a lack of transparency).
5. The arrangement is often a sign of the owner’s character – in most cases private equity firms benefit from multiple owners with complementary qualities. My experience is that single-owner firms are single-owner for a reason: the owner finds it hard to compromise and deal (closely) with other people. Additionally, it gives LPs and others comfort to know three or four top equiteers can work productively (even if at times with tension) using their complementary skills for the greater good.
6. Management fees are squandered to profit the owner - with a single owner, there is a real conflict regarding management fees. “Do I spend $x on business tools or tell staff to make do and save the money for dividend time?” Of course this could happen in multi-owner firms, but chances are they’ll keep each other honest. And, having multiple people with a financial interest in the management company will increase the chances that fees are put to good use.

To reiterate, I think it’s industrious and quite brave for a private equiteer to open up their own PE shop. But especially in private equity, it’s best to have a number of owners/partners with complementary contacts, skills, personas and experience. Multiple-owner firms are generally better investors, have better contacts, are better places to learn, are more enjoyable to work within and have more overall success.

You may be thinking that people like Buffett and Branson didn’t need others when they started their ventures, but we’re talking about PE firms run by relatively average earthlings (plus think of Gates and Jobs… and how Buffett fared with Munger). So, whether we talk about investment performance, esprit de corps (team morale), or access to capital, I really believe that multi-owner funds reign supreme.

Contrary to what some industry elitists may think, private equity doesn’t transcend the greater finance industry. It is exposed to the same biases, the same aversions, the same subjectivities, and the same contradictions. It’s foremost a sales game, but also a game of control and discipline. And with that in mind, I’d like to discuss a range of human behaviours rarely talked about in the industry. I believe they have a profound effect on performance and differentiation in the private equity industry.

• Emotional Bias: when emotions related to a potential outcome prematurely affect the decision, emotional bias is said to exist. In private equity, the emotions of closing a deal create a bias towards making the deal a success. I spoke indirectly about this in my recent post, the superficiality of most due diligence. In my opinion, this is the single biggest threat to the objective appraisal of a potential deal; we tend to want to close deals more than anything.
• Loss Aversion: this occurs because it is human tendency to rank avoiding a loss higher than receiving a gain. Ask yourself how you would feel if you lost 20% on your stock portfolio versus missing the opportunity of a 20% return on a potential investment. In private equity, we think it’s fine to miss great opportunities, yet sinful to invest poorly. This has become dogma in the industry because it appears a more conservative and agreeable argument.
• Congruence Bias: private equiteers love to talk about hypothesis testing, almost as if everyone else just shoots from the hip. The problem is, most private equiteers only test hypotheses directly and only reject hypotheses in extreme cases. For example, a typical hypothesis is “the company’s customer base is sufficiently fragmented?” The subjectivity alone creates bias, but so too does the use of direct testing (testing the positive case rather than the alternative case). One solution is to test the alternative case and have to prove “customer base fragmentation” beyond reasonable doubt.
• Framing Bias: framing is about using past experience and other external information to give something context. Framing makes daily decisions more efficient; if you consider every decision with a clean slate, you’ll go crazy. However, conventional framing threatens objectivity in private equity. Conventional framing shows what people want to believe, rather than what’s true. It’s important to learn to reframe important information to understand it in its entirety. For example, if a founder wants to sell a business, it doesn’t automatically mean it’s bad, he may just want to sail the world or climb Everest.
• Information Bias: when we talk about the competitive advantage of our firms, we talk about superior information.  When we negotiate deals with founders, we talk about asymmetric information. When we’re pressed on an issue we say we don’t have enough information. We just love information. However, as great as information may be, it needs to be the right information. Information bias is about seeking information that has less and less influence on the target decision. This occurs in private equity because more information is viewed as better analysis. But we lose site of the big picture; we get caught up in the process; we often fail to sit back and ask what the most important information could be.

I’ll leave it at those for now, which I think are the most salient cognitive biases that affect the industry. My suggestion to combating these biases is to acknowledge them, make them known, discuss them, and try to work around them with your team.  Pull each other up every time they seem to creep back, not in an adversarial manner, but in a constructive and friendly manner.

I trust you know the story, The Emperor’s New Clothes.

In short, swindlers promised the Emperor the finest suit from the finest cloth. The cloth was so exquisite it was apparently invisible to those unfit for office or unpardonably stupid. Not wanting to be categorised as such, the Emperor agreed the suit was exquisite and accepted it. As the Emperor paraded his new suit, the townsfolk commended him on his fine choice of loom.

Of course, there was no suit (it was invisible because it didn’t exist) and it took a small child to express this observation before everyone else caught on. The Emperor ended up short a few pesos for the privilege of running around town naked and the townsfolk were shown to be so impressionable that they couldn’t distinguish a clothed Emperor from a naked one.

There are plenty of messages in this fairy tale that transcend private equity (and most other industries). For me, it emphasises the importance of having a voice, thinking independently and being unabashed in expressing an opinion.

At the moment, if deals are looking a little naked (high multiples, poor fundamentals, underperforming industries, high risk, high valuation, etc), differentiate yourself by opposing the townsfolk (other general partners) and calling out said nakedness. Make it known you’re an independent thinker whom has learnt from recent events and is sensitive to current conditions. It’s the perfect time to be genuine in exposing your independent thinking; not so much for self-promotion, but for self-preservation and the preservation of your fund.

There’s much in the deal-making world, especially at the mid-market level, that is based on the concept of buying at a private market valuation and selling at a public market valuation (hence the title of this post).

A private market valuation simply refers to the value placed on private businesses, while a public market valuation refers to the value placed on public businesses. In the private business world, multiples are often in the range of 2x to 5x EBIT. In the public (listed) business world, multiples are more like 5x to 20x EBITDA. Note the reference to EBIT and then EBITDA, which stretches the gap even wider.

For listed businesses, the theory is they can purchase a private business at say 5x EBIT and immediately their own public market multiple is applied. There could be an instant doubling or tripling of value (just on paper of course). This is why so many listed companies are opportunistic with regard to acquisitive growth; there’s this concept of instant upside without the need to integrate or realize synergies.

Of course, such strategies are the antithesis of long-term value proponents, but in good times, they can work to create significant shareholder value.  The same carries across to private equity. At the mid-market level, funds have access to businesses on private market valuations. Assuming they grow these businesses (usually through acquisition) to a size conducive to an IPO, they can effectively sell them on a public market valuation. If you apply this multiple uplift to the results of organic growth initiatives, the introduction of debt, increased efficiency, etc., you can see it can easily create the bulk of additional value.

With the current unpleasantness, you may actually find that public multiples have dropped much more than private multiples, which somewhat hampers the effectiveness of this strategy. But, cashed up funds can still take advantage of the private market now, implement their improvements and be ready to exit when the public market is back to its old irrational self.